Dividend investing is a strategy that focuses on generating gains from dividend income, rather than capital growth. Historically, dividend payouts were a primary motivation for investors (Wharton School of Business professor Jeremy Siegel has pointed out that over 90% of the gain of the Dow since 1900 has been from reinvested dividends), but this mode of investing largely fell out of favor during the 1982-1999 bull market, as company valuations rose dramatically for such a sustained period.

Background

While the board may always opt to change the dividend, dividends are usually set at levels low enough to be able to sustain payment throughout the economic cycle (because dividend cuts are regarded as implying financial distress).

Dividend stocks have sometimes been disparagingly referred to as "widow and orphan" stocks as a reflection of their stable nature. However, after more than a decade of stock market volatility, low bond yields and stagnant money markets, it’s increasingly not just widows and orphans who see them as a key source of steady growth for their portfolios. As government debt hampers the growth of GDP in many developed countries such as the UK, dividend Investing is likely to return to popularity over the next few years. Among other things, dividend-paying stocks:

Offer passive income and some insurance if the stock falls in price (unlike non-dividend-paying shares where returns aren't realized until you sell).

Tend to be less volatile and do better in the long run than do nonpaying stocks (see S&P research below).

Are subject to more stringent financial discipline, since they must make regular payments to shareholders. You can fudge earnings but you can't distribute cash returns to your shareholders if you don't have the money.

Offer an inflation hedge if companies increase their payouts.

As David Stevenson notes, there are several schools of thought on how to approach dividend investing. One school maintains that a good dividend yield and a strong balance sheet should outweigh any consideration of future earnings growth. Another school of thought suggests that the yield isn’t quite as important as the potential for growth to accelerate compounding in the dividend.

Definition of a Dividend Screen

A popular approach to a dividend screen is simply to look for stocks with the highest dividend yield — the dividend divided by the original purchase price. This is often applied to stocks in a large cap index — in the US. this is known as the "Dogs of the Dow" (an investment strategy popularized by Michael B. O'Higgins in the early 1990s). However, getting decent dividends is only part of the battle. Making sure you pick stocks that can keep paying them — and increasing them — is much harder. Simply using the forecast dividend obviously relies on broker forecasts being a reliable source of information about the future — highly debatable!

For those looking to screen for dividend stocks, there are a wide of possible additional parameters that can be considered, including:

Dividend streak: Historic consistency is a useful signal as company boards tend to want to sustain a long history of dividend payments (barring a BP-like "black swan" event) -> For how many years has a dividend payment has been made consistently?

Payout Ratio: A low payout ratio (the percentage of earnings paid out in dividends) provides a margin of safety to ensure that dividends that are fully supported by earnings, whereas the dividend might be at risk with high payout ratios -> Is the payout less than or equal to, say, two thirds (and ideally in the 20-50% range) and/or below the median for companies in the industry?

Market capitalization: Generally, larger companies are considered safer bets than smaller firms because they have the product diversity and experience to survive unexpected turns in the economy -> Is the market capitalization greater than, say, £250 million?

Gearing: Dividend stocks should be supported by strong balance sheets, i.e., low debt-to-equity ratios and preferably lots of cash -> Is the debt to assets ratio below 50% or below the norm for the industry?

Short-Term Liquidity: A stock's current ratio is a useful tool for measuring short-term cash liquidity as short term debt can be catastrophic without suitable cash reserves -> Is the current ratio above two?

Dividend Growth Profile: Investors such as Benjamin Graham required that stock dividends at least keep pace with inflation -> Has the long-term DPS growth rate been greater than, say, 3% (or 10% in case of more growth-focused screens)? Has the annual payout increased every year? Is the current dividend yield greater than the five-year average dividend yield?

Earnings Growth: Dividends are not guaranteed, so one needs to make sure the business is earning enough to pay the dividend -> Is the long-term earnings growth rate consistent and above average for the industry?

Earnings Surprise: Another option might be to screen out stocks that have recently delivered a negative earnings surprise -> Have actual earnings fallen below analysts' estimates by more than 10% in the last three years? Have earnings estimates been revised more than 5% lower by analysts?

High ROE: Another way to assess the quality of the dividend profile is to look at the return on equity, which helps investors identify profit machines that will generate extra cash to distribute in the form of dividends. Is the ROE above 10%?

Excluding Utilities or REITs: Often these sectors are excluded in order to be screened separately since, otherwise, they tend to dominate the results and because they can have a different return profile.

Does Dividend Investing work?

Contrary to conventional wisdom, a Standard & Poor's study has shown that dividend-paying stocks actually do better in the long run in terms of total returns (price appreciation plus dividend income) — payers outdistanced nonpayers by 1.9 percentage points annually from 1980 through 2003. A study by David Dreman — in collaboration with Vladimira Ilieva of the Institute of Psychology & Markets — has also looked at a broader universe of equities: the 1,500 of the largest companies trading in US markets. From 1970 through 2003, the top fifth of the payers had an annual 14.5% total return vs. 8.8% for the lowest yielding group.

Watch Out For

As highlighted above, stratospheric yields can be tempting. However, often a super-high dividend yield can be a bad sign for a share, because it may mean the share price has fallen dramatically, reflecting market concerns about the underlying business, which means the dividend payment may not be sustained. Thus, it’s worth understanding the financial profile of the stock in detail.

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